1035 Tax-free Exchange
1035 tax-free exchange of a policy means the current policy is exchanged to another new and better policy, this could be possible because various reasons, for example:
- The insured's health condition improves therefore could get a better underwriting class
- The current policy wasn't shopped around aggressively therefore is not the best one
- The new life insurance policy has much better loan provisions, for example, a lot better interest rates
There is an important caveat of doing a 1035 tax-free exchange to rescue the old policy - the exchange should still be for the gross cash value of the life insurance policy with a loan attached. If a policy with a loan is exchanged for a policy without a loan, the policy holder is treated as having received a partial liquidation of the policy, which triggers income tax.
For example, a $750,000 universal life policy with a $200,000 cash value and a $150,000 outstanding loan balance, if it's exchanged to a new policy, the new one must have $200,000 cash value with a $150,000 outstanding loan balance, precisely matching the original one.
In our next blog post, we will discuss the final solution - surrender the policy.